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HCC Insurance Holdings, Inc. (NYSE:HCC)

Q1 2012 Earnings Conference Call

May 02, 2012, 09:00 a.m. ET

Executives

John Molbeck, Jr. - CEO

Chris Williams - President

Brad Irick - EVP and CFO

Mike Schell - EVP and Chief Property and Casualty Insurance Officer

Bill Burke, Jr. - EVP and COO

Analysts

Michael Nannizzi - Goldman Sachs

Doug Mewhirter - RBC Capital Markets

Ryan Byrnes - Macquarie

Operator

Ladies and gentlemen, this telephone conference call relates to HCC Insurance Holdings Inc. Before we begin, the company has requested that I read the following statement, which will govern the telephone conference today.

Statements made in this telephone conference that are not historical facts including statements of our expectations of future events or future financial performance are forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

Forward-looking statements involve inherent risks and uncertainties. And we caution investors that a number of factors could cause our actual results to differ materially from those contained in such forward-looking statements. These factors and other risks and uncertainties are described in detail from time-to-time in our filings with the Securities and Exchange Commission.

This conference call and the contents thereof and any recording, broadcast or publication thereof by HCC Insurance Holdings Inc. are the sole property of HCC Insurance Holdings Inc. and may not be recorded, rebroadcast, or published in whole or in part without the express written consent of HCC Insurance Holdings Inc.

Welcome to the First Quarter 2012 Earnings Release Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session.

I’d now like to turn the conference over to Mr. John Molbeck, Chief Executive Officer. Sir, you may begin your conference.

John Molbeck, Jr.

Thank you, operator. And good morning everyone and welcome to HCC’s 2012 first quarter conference call. Joining me today is Chris Williams, our President; Brad Irick, our Chief Financial Officer; Mike Schell, our Chief Property and Casualty Insurance Officer; and Bill Burke, our Chief Operating Officer is joining us for the first time today.

Brad will follow my initial remarks with financial highlights and Chris will comment about the quarter. But first a few highlights, for the quarter we had annualized operating return on equity of 11.1%, an increase in gross written premium of 5% to $682.7 million.

Net earnings of $82.6 million, net earnings per diluted share of $0.79. A GAAP combined ratio of 85.2% which included 1.3 percentage points of catastrophes. During the quarter we repurchased 2.2 million shares of our common stock at an average cost of $30.64, and increased book value per share by 2.5%. Importantly, our expense ratio was 25.1% for the quarter, a measure which continues to differentiate HCC.

Brad will now review with you our financial highlights. Brad?

Brad Irick

Thanks John. Net investment income was $57 million, up over 10% from the prior year. We achieved a long-term tax equivalent yield of 5% and a book yield of 4.1%.

Portfolio duration remained just under 5 years and our unrealized gain position increased nearly $20 million. We are pleased with our investment performance to-date, driven by strong cash flow and consistent yields.

We review the adequacy of our reserves across all of our major business lines each quarter including a review of catastrophe reserves. We recorded net reserves of $7.6 million related to catastrophes; $4 million of which related to U.S. storms that primarily impacted the public risk line of business and our U.S. P&C segment. The balance related to other small cats that impacted our property line of business. We make no adjustments to prior year cat reserves.

At quarter end our quarter reserves exceeded the actuarial point estimate by 4.8%, an increase from 4.2 percent at year-end, led by a better than expected actual experience and our professional liability segment. We purchased 2.2 million shares of our common stock for $67 million and an additional $31 million since quarter end.

We have a $129 million remaining under our current authorization and remain opportunistic buyers of our stock. Our debt-to-total-capital ratio increased to 14.6% as we continue to utilize our revolving credit facility to fund share purchases. At an average borrowing rate of about 1.6% of these funds, the facility is an effective low cost funding source allowing us to retain higher earning investments at the holding company.

Operating cash flow which excludes a major a large commutation in our Exited Lines was $103 million, an increase of more than $20 million from the prior year quarter. This represents our strongest first quarter operating cash flow in several years. The commutation is part of a proactive effort to finalize our exposure to run off excess workers’ compensation business that we exited a decade ago. This has been a successful effort with commutation payments of approximately $180 million since 2007.

Finally, we retrospectively adopted new accounting guidance for capitalization of policy acquisition costs this quarter, which reduced our equity by $18 million or $0.17 per share. The adoption had no impact on earnings reported for prior periods or our earnings expectations going forward. Chris?

Chris Williams

Thanks Brad. In the following remarks about our segments premium, I’m referring to net earned premium. Overall, our net earned premium for the quarter was up 8% when compared to 2011 with most segment showing improving rate environments.

Our renewal retention ratio was 84% for the quarter. U.S. property and casualty premium was up 11% for the quarter, and this segment produced a net loss ratio of 55%. Aviation premium increased not only year-over-year, this line produced a very satisfactory net loss ratio for the quarter, the 47% versus 59% to Q1 2011 due to fewer large losses. Premium growth in our public risk line offset decline in our E&O premium. Some of the lines of business included in our other category of our entertainment, sports disability as well as our 2011 new lines of business.

I have asked Bill Burke our new Chief Operating Officer to discuss the new lines.

Bill Burke, Jr.

Thanks Chris. We started three new lines of business in 2011, technical property, primary and excess casualty. We believe there will be a strong opportunity in these lines of business in the future.

For these lines 2011 was a year to get organized. We recruited experienced teams for each line and we built systems, process and agency relationships. We have seen a good flow submissions across these lines, as an example in the first quarter in primary casualty, we received over 2,500 submissions and we bound 31 accounts.

In 2011 we wrote $17 million of gross written premium in all three lines, in just the first quarter of 2012 we wrote $11 million of gross written premium and are forecasting gross written premium in excess of $60 million for the year.

Chris?

Chris Williams

Thanks Bill. John will be addressing the professional liability segment in his remarks. Our accident and health book led by our medical stop-loss product has continued the growth in Q4 2011 with premiums up 10% when compared to 2011. We are experiencing growth in terms of employee counts in HCC life, with insured lives up 145,000, and our average specific deductible has increased to 96,000.

Our U.S. surety and credit segment premium was down 7% for the quarter compared to 2011; however, we are still achieving a segment loss ratio of 23%. As the economy improves we are hoping to see an increase in contract in commercial surety opportunities.

Our international premium increased 18% versus Q1 2011. This year our energy, property treaty and direct and faculty property businesses have all seen price increases in the 5 to 10% range. We continue to monitor the use of our aggregates as this market continues to strengthen.

With a relatively benign catastrophe quarter, our segment loss ratio was 41% compared to 96% in 2011. Reflecting on our strong reinsurer relationships, reinsurer renewals throughout the first quarter finalized with minimal changes to terms and pricing.

John?

John Molbeck, Jr.

Thanks Chris. In our planning for 2012, we anticipated the continuation of the positive price movement we experienced in 2011 and a return to double-digit operating return on equity. This has happened.

Chris has outlined for you some of the positive pricing we experienced during the quarter, but having read some of the analyst quick summaries last night, I think people are somewhat confused between the growth in written premium and rate increases.

A couple of examples might be helpful. On E&O, if you look at the information we have provided and attached to our press release, gross written premium is down 14%, but our actual rate increase is 4.15%. This is because we took some actions in the first quarter of last year not to write certain classes of business primarily real estate related. So, trying to look at the gross written premium for the E&O line of business and trying to say the volume is down, therefore, you are not getting rate increases is not actually true.

Another example is on our D&O business, we actually increased our U.S. D&O business in the first quarter by just less than 10%. But the number for U.S. D&O business looks down, why is that, because as we have told everybody, we reduced our participation on diversified financial products.

And a final example is property treaty. If you look at property treaty line of business, we are down 3% for the quarter. We are actually getting rate increases of 7%, now why are we down 3% for the quarter, because we think there is going to be more attractive pricing later in the year. We have a finite amount of aggregate, that we’re going to dedicate to that class of business and we are going to be opportunistic as to when we use that aggregate capacity on the property treaty business. So, that’s just hopefully a little color to the issue about rate increases across our book of business.

Now I’d like to take a few minutes to talk about the professional liability segment. At the end of last year, we took the position on our U.S. D&O book of holding firm on pricing and derisking our overall book.

And while our initial efforts met with resistance, I’m pleased to report that we are now being largely successful in achieving 5 to 10% increases across the book of business while still derisking by reducing limits or moving up our programs where appropriate.

Internationally over the last decade the D&O loss environment has been more moderate than in the U.S. The international market has not hardened in the conventional sense, but the fear of losses turned the market. Major accounts that were seeking significant reductions in the first quarter were renewed flat. The London placements on those accounts reduced as London which has been more aggressive in the market as a whole seems to have pulled back.

Across the professional liability segment, we are seeing some interesting and meaningful new opportunities for accounts which either have unique circumstances or require the carrier to invest significant intellectual capital in an innovative solution.

Times remain interesting and quality has become more important quickly as brokers have found responses by some carriers unsatisfactory when stressed. It is certainly possible that some carriers currently providing excess D&O support or support on a quote share basis may withdraw from the class because of losses or volatility.

Finally, a brief word on diversified financial products. In the first quarter, we non-renewed 41% of our primary private equity policies. On the policies we did renew, we achieved a 52% average deductible increase and a 10% premium increase. We continue to re-underwrite this book as planned.

April was another moderate loss month for HCC and we fully anticipate a continuation of the positive pricing we have been experiencing and remain optimistic about the future.

Operator, with that I’d like to open up the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Michael Nannizzi with Goldman Sachs.

Michael Nannizzi - Goldman Sachs

Just one question if I could on investment income just $5 million higher than last year, quite a bit higher than the fourth quarter. It looks like the portfolio was a bit larger against both periods, but if I just maybe average yield or the average portfolio balance and think about investment income, it looks like the yield is about 25 basis points higher. So, just trying to get an understanding of what happen there and just one other follow-up. Thanks.

Brad Irick

As we mentioned, the growth in the portfolio is a big part of the performance. I’d just like to say first off we are pleased with the performance we had so far in the portfolio. Quarterly we can see some fluctuations, our expectation is that we will see that level off as the year goes on.

Michael Nannizzi - Goldman Sachs

Okay. So, but if I look, it looks like, I mean again point estimate looks like you have gone from 3.7 to almost 4%. It looks like the portfolio is couple $100 million larger, I get that the deployment and the credit line kind of offset each other. Operating cash was $100 million; unrealized gains were about $20 million. So, just trying to understand what drove the increase in yield, was it, or investment income, was it yield? Was there anything that changed on the investing side or how do we think about the increase in the portfolio?

Brad Irick

There are no significant changes to the portfolio, I think we have done a good job of finding some relative value and the longer end of the taxable – the tax exempt muni market – or I guess the line. But there is no significant changes to the portfolio.

Michael Nannizzi - Goldman Sachs

Okay. So, are there any sort of the yield has gone up decent amount in the quarter, both on a dollars basis and just a yield basis. I’m just having trouble understanding how, would you say in a declining spread environment, we see yields come down consistently over the last through the quarter and through the end of last year. I’m just trying to it would seem that there would have to be some duration expansion or just investment change

John Molbeck, Jr.

Mike, there is really no material change to the investment portfolio and I think as Brad said, I think over the course of the year, it's pretty much going to even out.

Michael Nannizzi - Goldman Sachs

And an A&H question. I know we saw a release earlier this year from the NAIC, has something about restricting small companies from self insuring, but clearly have you seen very solid growth in this line, kind of this year picking up from last year, just trying to get an understanding of that NAIC piece if it's relevant to your business at all. And just overall kind of where you are seeing in terms of that line of business in your franchise there?

John Molbeck, Jr.

I don’t think the NAIC restricted the number of lives that you can insure, I think they are potentially taking a position that might have an impact and the NAIC doesn’t regulate the states, the states regulate themselves. So, we talked about this on the last call, and very few of our accounts are in that. Craig gave the number last call, very few of our accounts are in that neighborhood of I think it was less than 50 lives. So, we don’t anticipate if any impact if so very insignificant impact on medical stop-loss business.

Michael Nannizzi - Goldman Sachs

And then if I could one more just gross written premiums versus net, so, it looked like gross premiums were up it look like in some in the segments that was lower. Is it because you have some of these sort of startup businesses, maybe you are retaining less of the growth year lines or did something else change in terms of how you are employing reinsurance?

John Molbeck, Jr.

I think you pretty much hit it on the button. The three new lines of business that Bill talked about earlier, we significantly just say on average 50% reinsure them, where on average, we almost maybe across the rest of the book we have 5 or 10% quota share reinsurance. So, as we grow that book and as we get comfortable with it, that 50% may well come down as has been our past practice.

Operator

Your next question comes from the line of Doug Mewhirter with RBC Capital Markets.

Doug Mewhirter - RBC Capital Markets

You explained the U.S. P&C, the new business, I was actually interrupted right in the middle of that explanation. First of all did you give any sort of impact of the three new businesses in the U.S. P&C to the overall growth rate or if you didn’t do you estimate an impact to how much contributed to this quarter, the three businesses?

Bill Burke

The numbers for the quarter in the first quarter of 2012 we wrote $11 million of gross written premium across those three lines. And in last quarter that was zero in 2011.

Doug Mewhirter - RBC Capital Markets

And your primary casualty business, is that written on excess paper or admitted paper?

Bill Burke

E&S business.

Doug Mewhirter - RBC Capital Markets

Also is there any you had no net reserve development, was there any underlying sort of canceling out positive or negative movements in the business lines that were material?

John Molbeck, Jr.

No.

Doug Mewhirter - RBC Capital Markets

And the other thing, this might be just the timing thing or business mix thing, but I noticed that your expense ratio has been pretty steady versus the fourth quarter. But your acquisition expenses went down quite a bit and your other bucket of expenses went up quite a bit, I didn’t know if there was, if it's just the way things happen in this quarter or if you reallocated something or it was just a business mix issue?

Brad Irick

I think what you may be seeing if you are looking at the acquisition cost ratio compared to what we reported at the end of the year, last year for the fourth quarter, that would have been pre the DAC adoption which would have impacted that from a comparability perspective. So, that’s probably what you are seeing from a policy acquisition perspective.

Doug Mewhirter - RBC Capital Markets

Okay, and so does that mean that it would be more of a all things being equal, that you would be looking at more of this sort of distribution, rather than it being a little more evenly distributed between acquisitions and other underwriting like low teens for each, rather than a high teens for acquisition and high single digits for other underwriting expenses?

Brad Irick

That sounds right.

Operator

(Operator Instructions) Our next question comes from the line of Ray Iardella with Macquarie.

Ryan Byrnes - Macquarie

This is actually Ryan Byrnes just filling in for Ray here. I just got a couple of quick questions. First on the D&O book, I think you mentioned it's kind of a 5 to 10% rate increase, but I guess it's blended between the traditional D&O and DFP book. I was wondering if you could, I know I couldn’t quite get the what the DFP increases were in a quarter. But I was wondering if you could just separate the two, what rate increases you save for the traditional versus the DFP, I guess the retentions between the two as well.

John Molbeck, Jr.

Well, I said with the rate increases for the DFP book on the private equity was about 10%. So, across the DFP book it was somewhat less but not materially less because primary private equity is a vast majority of that premium. On the U.S. D&O book for the actual quarter, I think the rate increases were around between 3 and 4%, but when I was referring to 5 to 10% I’m really referring to at the end of the quarter that was the price increases that we were able to achieve. And a lot of that was for business that we quoted in the first quarter but might not attach until the second quarter, because we are using quote 60 days ahead of the renewal date.

Ryan Byrnes - Macquarie

And then I guess on retention, I think I may have heard 41% retention rate for DFP, I’m just trying to figure out how it compares to the traditional D&O book.

John Molbeck, Jr.

60% retention, and the traditional D&O book will be 80%, but we are purposely not retaining a high percentage of that because we are trying to achieve very significant rate and deductible increases. Unfortunately, there is still lot of people out there willing to write that business for a lot less than we are.

Ryan Byrnes - Macquarie

And I guess what type of deductible increases are you guys achieving on your DFP book on the winter retaining?

John Molbeck, Jr.

Over 50%.

Ryan Byrnes - Macquarie

And what type of rate increases are you guys seeing in the medical stop-loss book?

Chris Williams

We are achieving right ahead of trend, which is obviously our goal and that book continues to grow.

Ryan Byrnes - Macquarie

And how does the rate increase I guess compare to the loss cost trend, just wanted to see if you guys were seeing any sort of margin expansion yet?

Chris Williams

No, we are right around trend, we track that fairly closely and we are quite happy with where it is.

Operator

There are no further questions at this time. I hand the program back over to management for any further comments or closing remarks.

John Molbeck, Jr.

Thank you, operator. I think we had a great quarter, we look forward to the next quarter and participating with you on the call. Everybody have a good day.

Operator

This does conclude today’s conference call, you may now disconnect.

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